Farm Credit Watch: FCS Hit by Another Accounting Scandal

The Farm Credit System has been hit by yet another accounting scandal, this time at Lone Star Ag Credit, which is headquartered in Fort Worth, Texas. Lone Star reported total assets of $1.72 billion on March 31, 2017. On Aug. 9, Lone Star issued a Notification of Non-Reliance on Previously Issued Financial Statements which stated in part that “management has determined the Association’s financial statements as of and for the year ended Dec. 31, 2016, as well as the three months ended March 31, 2017, should no longer be relied upon.” The notice stated that “during the second quarter of 2017, Association management discovered appraisal and accounting irregularities affecting a segment of the Association’s lending portfolio …Through our investigation of the portfolio to date, we identified loans totaling $3.3 million that should have been charged off in 2016, and an additional $5.8 million that should have been charged-off during the first quarter of 2017.”

This notice further stated that the issuance of these erroneous financial statements was “the result of a material weakness in certain internal controls.” A crucial question at this time: Has management identified the full extent of Lone Star’s internal-control weaknesses? Will additional losses surface as this accounting fiasco is investigated? Lone Star’s regulator, the Farm Credit Administration has not issued any statement regarding the Lone Star mess, although it did erase links to Lone Star’s call reports for 2016 and 2017 and noted that erasure in a deeply buried disclosure. The FCA apparently was unaware of the seriousness of Lone Star’s accounting problems as there were no FCA enforcement orders outstanding against any FCS association as of June 30, 2017. Surely if FCA examiners had uncovered Lone Star’s accounting shortcomings it would have issued an enforcement order (what the FCA calls a written agreement) against Lone Star. On July 31, the FCA appointed a new inspector general, Wendy Laguarda, a long-time FCA attorney. An early task for Ms. Laguarda should be to find out what went wrong at Lone Star and whether FCA examiners were slow to catch its internal-control weaknesses.

FCW readers may remember a similar episode at FCS Southwest (Southwest), the FCS association that served Arizona and a portion of southern California. I first reported on Southwest’s accounting problems in the November 2014 FCW. Those problems were so serious that Southwest effectively was forced by the FCA into a sort-of merger with California-based Farm Credit West on Nov. 1, 2015, as Southwest will continue to operate as an independent subsidiary of Farm Credit West for up to three years. Presumably that arrangement will enable future losses in Southwest’s loan book at the time of the merger to be borne by Southwest’s member/borrowers rather than Farm Credit West’s member/borrowers. The FCA and the Farm Credit Bank of Texas, which funds and supposedly oversees Loan Star, may have to cook up a similar resolution for Lone Star. That resolution may be complicated, though, by the fact that Lone Star’s territory overlaps several other FCS associations.

Tonsager stresses the importance of internal controls

On July 10, just a month before the Lone Star accounting mess surfaced, FCA chairman Dallas Tonsager spoke at the annual meeting of the AgFirst Farm Credit Bank about the importance of strong internal controls, stating that “having strong internal controls is central to building public confidence in the [FCS].” He went on in his speech to discuss the basics of providing a robust set of internal controls, such as “a loan officer should never have the authority to override controls designed to provide checks and balances in the loan-making process.” One can reasonably wonder if Tonsager had the Lone Star situation in mind when he wrote his AgFirst speech.

Let FCS institutions leave the FCS, along with their capital

In 2004, the Omaha-based Farm Credit Services of America, the largest FCS association ($27 billion in assets), serving Nebraska, Iowa, South Dakota and Wyoming, tried to sell itself to Rabobank, the large, globally active Dutch-based agricultural lender. To put it mildly, the FCS, led by its trade association, the Farm Credit Council, went ballistic, for if FCSA left the FCS, perhaps other well-capitalized FCS institutions might then leave, too, taking their capital with them. The FCS could quickly become a shell of its former self. A November 2004 article published by the Federal Reserve Bank of Kansas City observed that “the Rabobank acquisition could have paved the way for further purchases of FCS associations by private institutions, possibly leading to the end of the FCS.” AgStar (now Compeer Financial), another large FCS association, offered to merge with FCSA, but by then opposition to the Rabobank proposal was so intense that FCSA decided to remain independent. Had the Rabobank deal gone forward, FCSA would have had to pay an $800 million “exit fee” to the Farm Credit System Insurance Corporation (FCSIC), which guarantees the timely payment of principal and interest on the FCS’s Systemwide Debt Securities which provide most of the FCS’s funding.

Although the Rabobank-FCSA deal was not consummated, it did raise a critical public-policy question as relevant today as it was in 2004: Why shouldn’t an FCS institution be permitted to leave the FCS, taking all of its capital with it, if its members/borrowers thought the institution would fare better, and better serve its members, outside the FCS? There is a precedent for such a departure: In 1991 the California Livestock Production Credit Association, with just $14 million in loans, became Stockmans Bank. Congress approved that exit from the FCS in the 1990 farm bill and even waived the exit fee.

Today, many smaller FCS associations face extinction as larger associations gobble up smaller ones, creating large, multi-state associations increasingly focused on financing very large farming operations and agribusinesses. Almost without exception the smaller associations are extremely well-capitalized by commercial bank standards so capital would not be a barrier to seeking a commercial bank charter. All of that capital would be available to the former association if the exit fee payable to the FCSIC was waived, as occurred in the Stockmans Bank case. Arguably, a former association should be entitled to a return of the funds it paid into the FCSIC as its FCS borrowings were paid down. As banks, these former associations could then accept FDIC-insured deposits to replace the funding they formerly obtained from the FCS bank funding the association. These former associations also would be freed from the lending constraints now imposed on them by the Farm Credit Act.

While smaller FCS associations, which are similar in many ways to community banks since they serve relatively small geographic areas, are the most likely candidates to leave the FCS, some larger associations might decide to depart, too. Perhaps FCSA might again consider merging with Rabobank. CoBank could even consider exiting the FCS as it could then escape the lending constraints it must now operate under.

About Bert Ely

Bert Ely
Bert Ely is a consultant specializing in banking issues. He writes ABA's monthly Farm Credit Watch email bulletin.
More from Bert Ely >